What Is Stabilization Policy?
Stabilization policy is a strategy enacted by a government or its central bank aimed at maintaining a healthy level of economic growth and minimal price changes. Sustaining a stabilization policy requires monitoring the business cycle and adjusting fiscal policy and monetary policy as needed to control abrupt changes in demand or supply.
Key Takeaways
- Stabilization policy seeks to keep an economy on an even keel by increasing or decreasing interest rates as needed.
- Interest rates are raised to discourage borrowing to spend and lowered to boost borrowing to spend.
- Fiscal policy can also be used by increasing or decreasing government spending and taxes to affect aggregate demand.
- The intended result is an economy that is cushioned from the effects of wild swings in demand.
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Understanding Stabilization Policy
A study by the Brookings Institution notes that the U.S. economy has been in a recession for about one in every seven months since the end of World War II. This cycle is seen as inevitable, but stabilization policy seeks to soften the blow and prevent widespread unemployment.
A stabilization policy seeks to limit erratic swings in the economy's total output, as measured by the nation's gross domestic product (GDP), as well as controlling surges in inflation or deflation. Stabilization of these factors generally leads to healthy levels of employment.
The term stabilization policy is also used to describe government action in response to an economic crisis or shock such as a sovereign debt default or a stock market crash. The responses may include emergency actions and reform legislation.
The Roots of Stabilization Policy
Pioneering economist John Maynard Keynes argued that an economy can experience a sharp and sustained period of stagnation without a any kind of natural or automatic rebound or correction.
Prior, economists had observed that economies grow and contract in a cyclical pattern, with occasional downturns followed by a recovery and return to growth. Keynes disputed such theories that a process of economy recovery should normally be expected after a recession. He argued that the fear and uncertainty that consumers, investors, and businesses face could induce a prolonged period of reduced consumer spending, sluggish business investment, and elevated unemployment which would all reinforce one another in a vicious circle.
In the U.S., the Federal Reserve is tasked with raising or lowering interest rates in order to keep demand for goods and services on an even keel.
To stop the cycle, Keynes argued, requires changes in policy in order to manipulate aggregate demand. He, and the Keynesian economists who followed, also argued that an inverse policy could be used to fight off excessive inflation during periods of optimism and economic growth. In Keynesian stabilization policy, demand is stimulated to counter high levels of unemployment and it is suppressed to counter rising inflation. The two main tools in use today to increase or decrease demand are to lower or raise interest rates for borrowing or to increase of decrease government spending. These are known as monetary policy and fiscal policy, respectively.
The Future of Stabilization Policy
Most modern economies have stabilization policies, with much of the work being done by central banking authorities such as the U.S. Federal Reserve. Stabilization policy is widely credited with the moderate but positive rates of GDP growth seen in the U.S. since the early 1980s. It involves using expansionary monetary and fiscal policy during recessions and contractionary policy during periods of excessive optimism or rising inflation. This means lowering interest rates, cutting taxes, and increasing deficit spending during economic downturns, and raising interest rates, rising taxes, and reducing government deficit spending during better times.
Many economists now believe that maintaining a steady pace of economic growth and keeping prices steady are essential for long-term prosperity, particularly as economies become more complex and advanced. Extreme volatility in any of those variables can lead to unforeseen consequences to the broad economy.
What Are the Main Arguments For Stabilization Policy?
There are many reasons why a government would seek to implement stabilization policies. For one, such policies may help to even out erratic economic swings like recessions, which can lead to unemployment, price volatility, and reduced output. Stabilization policy can also cool an overheated market.
What Are the Main Arguments Against Stabilization Policy?
Critics of stabilization policy argue that it can pose harmful unintended consequences. Common policies—such as economic stimulus spending during recessions—can be costly, adding to a nation's deficit. They may also significantly boost spending power, which can lead to inflation.
What Is an Example of Stabilization Policy?
During the early months of the COVID-19 public health emergency, governments and central banks around the world adopted stabilization policies in an effort to mitigate the risk of severe recession. Examples of stabilization policy during this period included grants and low-interest loans for affected business sectors, stimulus checks for individuals and families, and the lowering of interest rates to keep money circulating in the economy.
The Bottom Line
Stabilization policy refers to government strategy designed to keep economic growth steady. Typically, stabilization policy is put in place by lawmakers and central banks, which enact a combination of fiscal and monetary measures. In other words, stabilization policy is designed to prevent the economy from extreme swings in growth or contraction.